PAUL KRAKE - Multiple headwinds are now upon us

Remember all those issues that you didn’t have to concern yourself about until Q4?

Multiple headwinds are now upon us

(This is part one of our weekly blotter. We will publish the latter part tomorrow.)

Remember all those issues that you didn’t have to concern yourself about until Q4? If I have learnt anything over the course of the last several years it is that pre-empting concerns based on policy shifts or geo-political concerns is pointless. Unless an event is going to have a direct impact on growth, profits or the cost of funding, then it can be ignored. Markets have focused on the here and now, preferring to let prevailing profit and growth scenarios drive returns. Guessing long term outcomes has been a flawed strategy.

As we enter Q4, a current snapshot of US asset markets paints a rosy picture. The SPX is coming off its best third quarter in six years. US profits are robust driven by strong economic growth. The US economy is still benefiting tremendously from President Trump’s tax cuts and consumer and corporate confidence remains at or near historical highs. It is easy to poke holes in the data. For example, this is an inventory build in anticipation of tariffs or that we are stealing growth from future quarters due to a reckless tax cut when the economy was at full employment but living in the here and now, the prevailing scenario is a strong one. The dollar and long dated US interest rates remain in a snug trading range with neither looking like a threat.

The rest of the world is less buoyant. Europe is muddling along as is China and emerging markets are littered with idiosyncratic basket cases. We saw contagion from Turkey in August, less so in September as a floor in Chinese equities and the Turkish Lira saw EM assets bounce back a bit. They still have underperformed US equities by a wide margin but sentiment towards emerging assets appears to have turned at the margin. That said, with US stocks and USD cash being to only major asset markets producing positive returns so far in 2018, consensus continues to be that US equities are the place to be. With EM (equity and credit), sovereign bonds, Investment grade bonds, high yield and commodities all producing negative returns, is it any wonder that the globe remains so enamored with US stocks?

We have all had it drummed into us over the years that financial markets are discounting mechanisms that price future events efficiently. I have never been a believer in this. Prices of late, across an array of assets have been very focused on what is happening today. Brexit was not a worry because that was a Q4 2018 story. The Italian Budget? We know Italian politics is a shambles, but this won’t be a concern until later in the year. Predicting the outcome of the US mid-term elections is something we can deal with in November and while it is pretty clear that US profit growth will slow in 2019, Q3 and Q4 profits will be fine so let us concern ourselves with that when the slowdown actually occurs. How far forward markets are prepared to look is impossible to answer but here is what I do know. This list of concerns, excluding US profits are concerns for Q4 and we are entering Q4. As the widening of Italian spreads showed us on Friday, these major headwinds cannot continue to be pushed to one side.

Will the Brexit debacle, the US mid-term elections and the Italian budget start to affect the outlook for growth, profits or the cost of funding? The answer for me is unequivocally yes and not just within the specific geography. The widening of Italian spreads will lead to EM spread widening, Euro weakness and a flight into quality sovereign bonds. The increasing inevitability of a no deal Brexit either due to the EU and UK not reaching agreement or more likely, Prime Minister May’s inability to get any agreement through Parliament will lead to pound selling and USD strength. A comprehensive rebuke of President Trump on November 6th would confirm that the pro-business agenda of President Trump has stalled. The House of Representatives will go back in to Democrat control, but the Senate looks increasingly tenuous for the Republicans. A loss of the Senate would create a narrative that US politics is heading back left and that is not a good scenario for equity multiples. While the arguments that gridlock is good for markets will get thrown around, it is undeniable that US stocks have benefitted from the action of President Trump and a narrative that these policies will eventually be reversed is something that will be taken poorly by investors.